This is a contentious issue in those marriages in which there is a business. This issue is the subject of books and dozens of court cases, so this article is but an introduction.
First, we need to determine to whom does the business belong. We call this characterization – is the business characterized as community property or as separate property. Was it started before marriage? Did both spouses work in the business? Was it inherited? Was it purchased during marriage with separate funds? Was it started during marriage? These initial questions need to be answered to direct your legal teams efforts in this area.
Courts will generally not continue with joint ownership of a community business after a dissolution of marriage and will value the business and require a payment to the other spouse from the spouse who remains to operate the business.
A separate property business (one owned prior to marriage, one inherited during marriage or one purchased during marriage with separate funds) can still have value to the community. This value is a calculated value and the value methodology is derived from the Pereira or the Van Camp line of cases. The community will not own the business, but will receive a financial interest which must be paid to the community by the operating spouse. This is called an equitable apportionment, which I will further describe below.
A community business is valued generally at a time close to trial. However businesses which are either alter egos for the operating spouse (sole practice doctor, lawyer or other professional) or businesses for which the operating spouse provides contributions so significant to the business success that the court finds that it would not be equitable to let the community continue to benefit from the post separation efforts of the operating spouse, will be valued at the date of separation.
Let’s digress for a moment. What is the date of separation? This issue is the subject of another article, however, historically, this date has been generally defined as the date the parties decide that a final breakdown in their marriage has occurred and this decision is thereafter supported by the acts of the parties, which can be objectively seen to support a final breakdown. In July, 2015 however, the California Supreme Court has ruled that the date of separation must relate to the parties date of physical separation – i.e. when one moves out – with an exception only in unusual circumstances. Community property can be created during marriage, i.e. before the date of separation. Separate property can be created after the date of separation. The reason for this rule is that court’s value a business at the date of separation because under the rule just stated, the community cannot be enhanced by the separate property efforts (efforts after the date of separation) of the operating spouse.
What is Equitable Apportionment? Family law court is a court of equity. This means that the court makes decisions based on the law, but also on what is fair or equitable for the parties using the circumstances of the particular case. There are many maxims of equity, which will not be discussed here. But in many situations, the court will apply equitable apportionment to give the community a financial interest in one spouses separate property. This can most easily be thought of using a pre marital residence, in which the married couple live and use their community income to pay the separate owner’s mortgage payments. The community does not obtain a legal interest in the separate property residence, but the community can obtain an equitable interest, based on the principal paid down using community funds coupled with a percentage of the appreciation during the period of the marriage. Separate property business interests may similarly be equitable apportioned between the separate property owner and the community using different theories of apportionment than the one described for the residence.
In valuing a community property business, a forensic accountant is typically retained by the party. The CPA will review the business balance sheet and make adjustments to properly state the balance sheet on an accrual basis. For basics, a Balance Sheet is a listing of all the assets and debts of the business. Accrual basis means that the Balance Sheet shows money owed to the business and money the business owes as well as other assets and liabilities.
The next step in the valuation process is to determine the Goodwill of the business. This is a mathematical calculations, using valuation theories and the judgment of the Forensic CPA to determine the appropriate value for Goodwill. Goodwill is generally thought of as the value of the ability of the business to earn greater than normal earnings which similar business’ earn.
Many if not most small businesses are life style businesses, where the parties have paid many of their personal expenses through the business and deduct them in order to reduce income taxes to better support their lifestyle. These are not at all unusual, but during a divorce, the spouse who had limited knowledge of these personal expenses being paid through the business is often highly suspicious of this practice. The forensic CPA will look for and make accounting entries in their report to eliminate personal expenses or add back income which was not reported in the accounting system of the business. Once the total adjusted net earnings of the business have been determined (net means after subtracting the legitimate business expenses, including a reasonable salary for the spouse who is operating the business), this amount is compared to published studies on the type of business to determine whether or not this business has greater, equal or lesser earning ability than the average of the published studies. The CPA then uses their judgment and valuation theory to determine the appropriate mathematical model to apply to the business net earnings to arrive at the goodwill of the business, which is added to the adjusted balance sheet to arrive the total value of the business. This value is typically contested by the other spouse and through either negotiation or trial, the ultimate value is determined and that value is divided between the parties.